We may well be in an entirely new phase right now. For months, the equity market had this uncanny ability to rally on any good news, as the psychology took hold that less-negative data was a positive (like having your golf score go up but at a slower rate). Any adverse data that caused a retracement from March to August was treated as a buying opportunity.

But having gone from pricing in -2.5% real GDP growth at the lows to +4.0% now, it looks like Mr. Market is becoming a little more discerning in terms of interpreting the economic data. Even before yesterday’s [Tuesday] selloff, the equity market was no longer rallying on “good news”, and there were many such data points that rallied the economics community to the sidelines, pom-poms and all, in order to cheerlead the incoming information – durable goods orders, all the housing data, consumer confidence, and even Bernanke’s re-appointment. Three months ago, the stock market would have been rallying like mad based on all these goodies – but it hasn’t this time around.

Yesterday was an exclamation mark on just how much is priced in because ISM surged to 52.9 and pending home sales soared 3.2% MoM (best level since June, 2007, no less) – though construction spending in June did dip 0.2% as declines in nonresidential and public construction overwhelmed the recovery in the residential sector. And there was also the news that global chip sales rose in July for the fifth time in as many months – by a ripping 5.3% (though still down 18.2% YoY). Not only was the stock market down 2.2% yesterday, but it was on higher volume to boot (+19% on the NYSE) – distribution days are never very good signposts.

As everyone knows, we have been very busy working hard to identify what the markets are discounting in terms of future economic growth and came to the conclusion months ago that the equity rally in particular was leapfrogging the outlook. It’s one thing to price out the recession, which is what a 20% rally suggests, but once you surge over 50% from any low the market is usually in year two of the recovery phase. Even if the economy does better than we think it is capable of, the reality is that the stock market has discounted a whole lot of growth – from our lens, two year’s worth. We can debate the macro outlook, to be sure, but the market does look now as though it is going to sit and wait for the fundamentals that have been priced in to come to fruition.

From a purely technical standpoint, which is beyond our purview but must be addressed since so much of the bear market rally was technically-based, a 50% retracement would imply a corrective phase to 840-850 on the S&P 500, which would imply that the market is back to pricing in a 2.0% growth trajectory for the coming year (precisely where the corporate bond market is in terms of its embedded outlook for growth). If in fact we are in a corrective phase, this would mean at least 15% downside potential in equity prices, and a shift towards defense, stability and income at a reasonable price would seem prudent after a rally that was led mostly by junk and cyclical securities.

Presently, it is still unclear whether or not we are going to necessarily undergo this correction – so many times in this bear market rally buyers have come in after the type of giveback we have endured, which has been just 3.2% thus far from the 1,030.89 interim peak on August 27. A break below the most recent low of 979.73 back on August 17 would probably be very meaningful in this sense, and again, what is different this time is that we just came off a week with some new information – Mr. Market is no longer rallying on good news. And, this is exactly what the tell-tale sign was back in 2002, when after a huge rally, the S&P 500 failed to rise on the day that the ISM broke above 52.0 as it did yesterday (when the March 2002 data were released on April 1 of that year) – that was an early sign to take profits because the market slid more than 30% over the next six months.

Similarly for the bond market, it would be critical for the yield on the 10-year note, now at 3.37%, to “take out” the interim July 10 low of 3.32% – if that happens, a break towards 3.00% is very probable.